First Activist Victory Linked to Telecom Break Up: Five Questions for Investors
Citi GPS Opinion
08 May 2018 20:50:35 ET – Last Friday, Elliott Advisers, an activist investor with a 9% stake in Telecom Italia, won a shareholder vote that secured two-thirds of the Italian incumbent’s board seats for its proposed candidates made up mostly of independent Italian business figures. This was the first proxy shareholder vote victory in Elliott’s 40- year history. Its rival, Vivendi, effectively lost control of the board by winning only one- third of the seats, despite owning 24% of Telecom Italia and being backed by the current popular CEO. It was a close win in a widely-watched shareholder battle. Unsurprisingly, the battle was full of mutual accusations of corporate governance failings and inconsistent communication. Some papers characterized the battle as a fight for the future of modern capitalism. Vivendi focused on stability and its alignment with the current CEO. Meanwhile, Elliott managed to secure support of the leading proxy advisors on corporate governance grounds. The Italian government, which indirectly owns almost 5%, also supported the Elliott slate.
We see the following two issues as most crucial in the battle. First, Elliott’s plan for Telecom Italia called for a fixed-line network (NetCo) spin-off as well as flexibility around infrastructure consolidation and the future control of infrastructure assets, including the NetCo. Secondly, Elliott held a view that the board should be composed of independent, mostly local business people as opposed to insiders linked to a specific industry or shareholder. We see the Telecom Italia vote as the first open shareholder vote on these highly important issues in the telecom industry. In the pages that follow, we focus on the broader implications of this unique shareholder activist victory on the telecom industry in Europe and beyond.
Telecoms Under Siege Are Often Wrong To See Salvation in NetCo/ServCo Synergies
The telecom industry is under major pressure. On the service side, global technology companies have pushed telecoms into retreat. On the network side, it is increasingly clear that certain assets such as towers and fiber may be best managed as a shared utility-like infrastructure (see our report Re-Birth Of Telecom Monopoly from November 2014). Infrastructure investors are becoming increasingly active in the pure telecom infrastructure space, especially in advanced economies with low density of fiber-to-the- home (FTTH). For example, we have recently seen such activity in Europe in Italy (government-backed Open Fiber established by Enel and CDP), the U.K. (recent acquisition of CityFibre by a Goldman Sachs-backed consortium), Denmark (recent acquisition of TDC by a consortium led by Macquarie) and in Germany. Telecom companies are concerned that other industries may ‘eat’ their businesses piece by piece. As a response they often cling to synergies between infrastructure and services (or NetCo/ServCo) — something that rivals from other industries cannot easily replicate.
Unfortunately, we think that such combination strategies may prove short-sighted and counterproductive. First, the nature of the infrastructure and service businesses differs substantially. Second, such strategies may partially work in the short-term, allowing telecoms to operate otherwise non-competitive infrastructure and service businesses but this also requires them to retain major structural inefficiencies, making their businesses inflexible and vulnerable in the long term. Third, such strategies may put telecoms on a collision course with their regulators, who are increasingly focused on the quality (not the duplication) of infrastructure and the versatility of its use for digital services.
The recent history of Telecom Italia provides a typical example of this. The plan put forward by Elliott Advisors essentially called for a departure from the NetCo/ServCo synergy-driven strategy. Instead it sees value creation from a potential breakup of the company including possible regulatory benefits. The plan would also entail the transformation of Telecom Italia’s ServCo into a competitive technology, connectivity, and service-driven business, which we call DIGITECCS.
In our April 2018 report Are markets starting to envisage changing roles of telecoms and tech?, we presented data showing growing investor support for telecoms to refocus away from NetCo/ServCo synergies. This includes stock market responses to specific moves in the Czech Republic, Denmark, and New Zealand, among others. In the case of Telecom Italia, the stock market responded positively to the announcement of the Elliott Associate plans earlier this year. The instant market reaction to Friday’s victory by Elliott Advisors was also positive, despite the obvious uncertainty that will now surround Telecom Italia.
Telecom Executives Can No Longer Take Investors’ Support For Their Infrastructure Control ‘Red Lines’ For Granted
A question naturally arises: Do executives of telecom companies also see the above- mentioned trends? Surely it is in their interest to boost shareholder value. Telecom Italia’s highly-regarded CEO, had already presented a plan inspired by similar thinking. Does investor activism, takeovers by non-telecom investors, self-inflicted disruption, and departure from long established telecom business models really serve the best telecom shareholder interests? We provide three reasons why we think they may. First, large telecoms suffer from internal inertia, because structural changes entail significant changes in job roles, including generational changes favoring young, creative, and software/customer-focused workforce. Second, industry executives often have ‘red lines’ linked to controlling key infrastructure. Veteran telecom executives may simply not be prepared to contemplate a different type of business, irrespective of the value implications of a potential breakup. Finally, telecom executives may not have sufficient incentives to fundamentally transform or break up telecom companies. The potential rewards for doing so may simply not be high enough to compensate for the higher risk and smaller size of the business.
The Telecom Italia vote in our view sends a clear signal to the entire telecom industry that a growing number of investors may no longer tolerate infrastructure control ‘red lines’, which are endorsed by many telecom insiders including boards, executives, certain business partners, consultants, investors, and analysts. If value-accretive opportunities to ‘trade’ control in some infrastructure for financial, competitive, or regulatory benefits arise, investors may want telecom companies to consider those with an open mind. In other words, they want to look at telecoms as structural and digital transformation opportunities, not only as legacy businesses. Shareholders, who voted to support the Elliott Advisor’s slate, in our view also voted for a more open mind about strategic options, despite short-term risks to the company. For those who supported the Vivendi slate, some may have been concerned about growing government involvement in Telecom Italia and, purely theoretically, potential future conflicts of interest involving Elliott’s activity in Italy (although there is nothing specific known as of now). These may be valid points, but they do not necessarily contradict the key conceptual points from Elliott’s strategic plan.
Regulators and Infrastructure Investors May Strengthen the Economic Case for a NetCo/ServCo Breakup
The economic case for the NetCo/ServCo breakup of telecoms may also evolve over time. It is possible that in a number of markets, it may now be approaching a point where it is hard for prudent investors to dismiss it. We see two main reasons for this:
- In their effort to promote investments into infrastructure shared among market players, e.g., into fiber, regulators can make the control of certain infrastructures by telecom incumbents more expensive. For example, the EU is contemplating a plan which gives certain regulatory benefits exclusively to wholesale-only independently-controlled networks. The Italian government has helped to fund Open Fiber, an independent fiber network directly challenging Telecom Italia. The U.K. telecom regulator Ofcom, has a history of pushing for independence of the incumbent’s network, i.e., Openreach. It recently also warned the incumbent operator (BT) to change and innovate, invoking historical examples of failed businesses such as Kodak, Blockbuster, and Polaroid.
- Infrastructure investors, who historically avoided telecoms in favor of other utility industries, are beginning to change their attitude. They are mainly looking for opportunities in independent, open infrastructure such as towers and fiber, which is seen as strategic by governments. If the leading telecoms agree to cease control in some of their infrastructure, they could potentially benefit from ‘de-risked’ valuations that such investors may put on these assets. Otherwise, infrastructure investors can pursue a route of building new open networks, undermining the leading telecoms’ infrastructure. This is currently happening in Italy, Germany, and the U.K.
Five Key Questions Telecom Investors Should Ask
In summary, the Elliott’s victory in the Telecom Italia shareholder vote shows that, going forward, telecom executives need to consider the interests of a growing number of shareholders who may see value creation in the NetCo/ServCo breakup. We consider building competitive strengths of the service businesses (ServCos) around a combination of DIGItal TEChnology, Connectivity and Service (DIGITECCS) in preparation for potential value accretive NetCo/ServCo breakups, as the right strategic response, especially ahead of 5G. We see telecoms, for example in the U.S., Japan, Korea, Spain, Russia, Turkey, some of the Gulf countries, and beyond, already being active in the DIGITECCS area, although with varying views about the future of telecom infrastructure. Meanwhile, amid fading shareholder and regulatory support, the leading European incumbents have found unusual allies in their trade unions. ETNO, an association of the leading European telecoms, issued a joint statement with their trade union partners last month pushing back on the proposed EU code, which could give a benefit to independent infrastructure companies and hence indirectly promote the NetCo/ServCo model. Since we see structural inefficiencies as one of the key challenges facing legacy telecoms, we view alignment with trade unions as important. We think that the following questions are crucial for telecom investors:
1. Who is management of telecom companies aligning with, which incentives does it have, what ‘red lines’ on infrastructure control does it honor and most of all, what impact does this all have on shareholder value creation?
2. Which telecom companies are most ripe for takeovers inspired by structural changes, shareholder activism, and other shareholder-driven attempts to create value through structural changes?
3. Which industries and companies will benefit from possibly prolonged inefficiencies of legacy telecoms?
4. How best do you look at telecom value creation with an open mind, not influenced by the possibly biased long held views of many telecom industry insiders?
5. If crucial shareholder votes involving proposed structural changes to incumbent telecoms occur, how should the voting shareholders assess upside from such changes against potential risks?Authors: Authors: Authors: Dalibor Vavruska,Authors: Dalibor Vavruska,